The three alternative approaches to income measurement. Please note that because Approach 2 is a hybrid of Approach 1 and Approach 3, the discussion of Approach 2 follows the discussion of Approach 3
Approach 1: Economic Value Changes Recognized on the Balance Sheet and Income Statement When Realized
Just as the conventional method of asset and liability valuation leans on historical value approaches (but with a decreasing emphasis), the conventional approach to income measurement relies on realization as the trigger for recognizing components of income. ‘‘Realization’’ for revenues occurs when firms receive cash, a receivable, or some other asset subject to representationally faithful measurement from a customer for goods sold or services performed (or when the firm satisfies a liability to a customer by delivering goods or services owed). The receipt of this asset validates the amount of the value change, and accountants characterize the firm as having realized the value change. This ensures that the amounts recorded as revenue are both relevant and representationally faithful. For expenses, the concept of ‘‘realization’’ is somewhat different because expenses frequently reflect the consumption of assets or incurrence of liabilities, which often is not as directly observable as an event like a sale to a customer. The conventional way of thinking about recognizing expenses is that they are matched to the revenues they help generate, but this convention applies only to certain expenses that can be clearly linked to realization of revenues, such as costs of goods sold or selling commissions. For example, a sale of lumber by The Home Depot indicates that revenues have been realized, which then triggers derecognition of the inventory and the accompanying recognition of an expense for cost of goods sold. More commonly, expenses are recognized in the particular period in which they are realized by the consumption of resources (such as paying salaries to employees) or the passage of time (such as rent or interest).
As presented in the discussion of asset and liability valuation, delaying the recognition of value changes for assets and liabilities until triggered by some realization (such as a sale or consumption) means that the balance sheet reports assets and liabilities at historical values. When historical values are used, valuation changes in assets and liabilities are not recognized until they are realized, meaning that some event (such as a sale) establishes a reliable basis for measuring and reporting the changes in the assets and liabilities on the financial statements. In this case, realization affects the balance sheet and the income statement simultaneously, which characterizes Approach 1. For example, a firm that holds land it acquired at $300,000 but is now clearly worth $900,000 does not recognize the $600,000 gain until the land is actually sold. An intuitive way to think about Approach 1 is that the accountant takes a ‘‘wait-and-see’’ approach. Note that the receipt or disbursement of cash is not a requirement for realization. Because cash flows may precede, coincide with, or follow the value change, the balance sheet utilizes various accruals and deferrals as placeholders for cash flows (such as accounts receivable, accounts payable, or prepayments).
Approach 3: Economic Value Changes Recognized on the Balance Sheet and the Income Statement When They Occur
Approach 3 compels firms to revalue assets and liabilities to fair value each period and recognize the unrealized gains and losses in net income in that same period. This approach to income recognition aligns well with the current value approach for assets and liabilities because the changes in economic value are reflected on the income statement even if they are not yet realized. With exceptions discussed next for Approach 2, U.S. GAAP generally does not permit firms to revalue assets upward for value increases, which would recognize the unrealized gain as part of net income. The reason for this is that the combination of representational faithfulness concerns for the estimated increases in economic value and managers’ self-interested incentives to report higher book values and income might lead to poor quality financial statements (despite the potential for greater relevance). Instead, firms must await the validation of such increases in value through a market transaction (that is, realization) to provide a sound, reliable basis for recognizing the gain. U.S. GAAP is not symmetric regarding recognition of value increases and decreases.
Approach 1: Economic Value Changes Recognized on the Balance Sheet and Income Statement When Realized
Just as the conventional method of asset and liability valuation leans on historical value approaches (but with a decreasing emphasis), the conventional approach to income measurement relies on realization as the trigger for recognizing components of income. ‘‘Realization’’ for revenues occurs when firms receive cash, a receivable, or some other asset subject to representationally faithful measurement from a customer for goods sold or services performed (or when the firm satisfies a liability to a customer by delivering goods or services owed). The receipt of this asset validates the amount of the value change, and accountants characterize the firm as having realized the value change. This ensures that the amounts recorded as revenue are both relevant and representationally faithful. For expenses, the concept of ‘‘realization’’ is somewhat different because expenses frequently reflect the consumption of assets or incurrence of liabilities, which often is not as directly observable as an event like a sale to a customer. The conventional way of thinking about recognizing expenses is that they are matched to the revenues they help generate, but this convention applies only to certain expenses that can be clearly linked to realization of revenues, such as costs of goods sold or selling commissions. For example, a sale of lumber by The Home Depot indicates that revenues have been realized, which then triggers derecognition of the inventory and the accompanying recognition of an expense for cost of goods sold. More commonly, expenses are recognized in the particular period in which they are realized by the consumption of resources (such as paying salaries to employees) or the passage of time (such as rent or interest).
As presented in the discussion of asset and liability valuation, delaying the recognition of value changes for assets and liabilities until triggered by some realization (such as a sale or consumption) means that the balance sheet reports assets and liabilities at historical values. When historical values are used, valuation changes in assets and liabilities are not recognized until they are realized, meaning that some event (such as a sale) establishes a reliable basis for measuring and reporting the changes in the assets and liabilities on the financial statements. In this case, realization affects the balance sheet and the income statement simultaneously, which characterizes Approach 1. For example, a firm that holds land it acquired at $300,000 but is now clearly worth $900,000 does not recognize the $600,000 gain until the land is actually sold. An intuitive way to think about Approach 1 is that the accountant takes a ‘‘wait-and-see’’ approach. Note that the receipt or disbursement of cash is not a requirement for realization. Because cash flows may precede, coincide with, or follow the value change, the balance sheet utilizes various accruals and deferrals as placeholders for cash flows (such as accounts receivable, accounts payable, or prepayments).
Approach 3: Economic Value Changes Recognized on the Balance Sheet and the Income Statement When They Occur
Approach 3 compels firms to revalue assets and liabilities to fair value each period and recognize the unrealized gains and losses in net income in that same period. This approach to income recognition aligns well with the current value approach for assets and liabilities because the changes in economic value are reflected on the income statement even if they are not yet realized. With exceptions discussed next for Approach 2, U.S. GAAP generally does not permit firms to revalue assets upward for value increases, which would recognize the unrealized gain as part of net income. The reason for this is that the combination of representational faithfulness concerns for the estimated increases in economic value and managers’ self-interested incentives to report higher book values and income might lead to poor quality financial statements (despite the potential for greater relevance). Instead, firms must await the validation of such increases in value through a market transaction (that is, realization) to provide a sound, reliable basis for recognizing the gain. U.S. GAAP is not symmetric regarding recognition of value increases and decreases.
Firms must generally write down assets when fair values decrease below book values and recognize the decline in economic value immediately in income, but this is generally not permissible for increases in fair values. For example, suppose Smithfield Foods has live hog inventory valued at $882 million. Despite the fact that swine flu is not spread by eating properly cooked pork, a swine flu epidemic sends the market price of live hogs down approximately 5% on the Chicago Mercantile Exchange. As a consequence, Smithfield Foods’ inventory is overstated by $44 million. This decline in inventory fair value is recognized on both the balance sheet and income statement based on the new market prices. The new value of live hog inventory is $838 million, and this decline in economic value is recognized in income as a lower-of-cost-or-market adjustment for inventory of $44 million.
In contrast, IFRS allows for a number of situations where firms are permitted to increase asset valuations. For example, upon initial adoption of IFRS, firms may elect to value property and equipment at fair value. In addition, firms can record investment property (such as rental property), intangible assets, and some financial assets at fair values even when those fair values rise above carrying values. Note, however, that when firms report unrealized changes in economic value in current earnings under IFRS, additional disclosures must accompany the use of fair values, including the methodology of determining fair value. These additional disclosures are an attempt to increase the transparency of the fair values and therefore the representational faithfulness of these amounts. Also note that under IFRS, if a firm elects to recognize increased fair values of assets, it must do so for entire classes of similar assets (for example, all real estate, not just single properties) and it must continue to revalue such classes of assets thereafter (even if fair values decline). These requirements are meant to discourage firms from cherry-picking which assets to revalue upward and when.
Approach 2: Economic Value Changes Recognized on the Balance Sheet When They Occur but Recognized on the Income Statement When Realized
The value changes of certain types of assets and liabilities are of particular interest to financial statement users and are measurable with a sufficiently high degree of reliability that U.S. GAAP and IFRS require firms to revalue them to fair value each period. U.S. GAAP and IFRS recognize, however, that the value change is unrealized until the firm sells the asset or settles the liability. The ultimate realized gain or loss will likely differ from the unrealized gain or loss each period, particularly if the market values of the underlying assets or liabilities are volatile. Therefore, U.S. GAAP and IFRS require firms to delay including the gain or loss in net income until realization of the gain or loss occurs.
The most common types of unrealized gains and losses that receive treatment under Approach 2 include:
In contrast, IFRS allows for a number of situations where firms are permitted to increase asset valuations. For example, upon initial adoption of IFRS, firms may elect to value property and equipment at fair value. In addition, firms can record investment property (such as rental property), intangible assets, and some financial assets at fair values even when those fair values rise above carrying values. Note, however, that when firms report unrealized changes in economic value in current earnings under IFRS, additional disclosures must accompany the use of fair values, including the methodology of determining fair value. These additional disclosures are an attempt to increase the transparency of the fair values and therefore the representational faithfulness of these amounts. Also note that under IFRS, if a firm elects to recognize increased fair values of assets, it must do so for entire classes of similar assets (for example, all real estate, not just single properties) and it must continue to revalue such classes of assets thereafter (even if fair values decline). These requirements are meant to discourage firms from cherry-picking which assets to revalue upward and when.
Approach 2: Economic Value Changes Recognized on the Balance Sheet When They Occur but Recognized on the Income Statement When Realized
The value changes of certain types of assets and liabilities are of particular interest to financial statement users and are measurable with a sufficiently high degree of reliability that U.S. GAAP and IFRS require firms to revalue them to fair value each period. U.S. GAAP and IFRS recognize, however, that the value change is unrealized until the firm sells the asset or settles the liability. The ultimate realized gain or loss will likely differ from the unrealized gain or loss each period, particularly if the market values of the underlying assets or liabilities are volatile. Therefore, U.S. GAAP and IFRS require firms to delay including the gain or loss in net income until realization of the gain or loss occurs.
The most common types of unrealized gains and losses that receive treatment under Approach 2 include:
- foreign currency translation effects.
- fair value gains and losses on financial assets classified as available-for-sale investments and derivatives designated as hedges of future cash flows.
- certain adjustments to pension and post-retirement benefit obligations.
To put this in context, consider the actual monthly share prices of Reynolds American Inc. (NYSE: RAI) during calendar year 2012, shown graphically in Exhibit 2.8. Reynolds American is one of the largest tobacco companies in the world, and its stock is held in many investment portfolios. Consider how the price fluctuations in RAI’s stock would have affected the financial statements of firms holding this investment during 2012. The stock price ended the year at $41.43, virtually unchanged from its price at the beginning of the year, $41.42. However, firms report results quarterly, so a firm with a December fiscal year-end would have seen the value of an investment in Reynolds American virtually unchanged at $41.44 at the end of first quarter; increase 8.3% from the first-quarter close to $44.87 at the end of the second quarter; decrease 3.4% to $43.34 during the third quarter; and finally fall another 4.4% back to $41.43. If applied to each quarter’s financial statements, Approach 3 would have resulted in a volatile seesaw of net income recognition across the four quarters, although the year-over-year valuation of the investment was essentially flat. The intent here is not to argue that either approach is superior to the other, but just to highlight their differences.
As a hybrid of Approaches 1 and 3, Approach 2 attempts to capture the relevant economic value changes recognized for assets and liabilities under Approach 3, using the current value approach for asset and liability valuation. At the same time, Approach 2 incorporates the representational faithfulness feature of Approach 1 by delaying recognition of the economic value change in net income until the change is realized in a market transaction. Instead, such changes appear as part of other comprehensive income on the statement of comprehensive income.
The practice of delaying the recognition of fair value changes in net income under Approach 2 presumes that the investors assign greater relevance to net income as the summary measure of performance for a firm, but view amounts recognized as other comprehensive income as being of secondary relevance. Indeed, in a study of comprehensive income disclosures shortly after they were first required, it was concluded that investors do not perceive other comprehensive income to be important components of a firm’s performance, given net income
However, numerous other studies have demonstrated a strong association between security prices and underlying fair value estimates and between the changes in fair values and stock returns. In addition, the volatility of fair value changes reflected in comprehensive income has shown to explain numerous measures of risk for commercial banks. Thus, overall it is clear that investors view fair value amounts as relevant despite the risk that such amounts might be less representationally faithful than historical valuations.
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